After a bumper year, what next for emerging markets?
Investors in emerging markets have had a rough ride in recent years, but the outperformance of China and technology stocks could be a cause for optimism.
Emerging markets stocks make up 12 per cent of the global stock market. Thirty years ago, these stocks represented less than 1 per cent of the world's investable equity market capitalisation.
These markets are dynamic and have changed dramatically in the past three decades, and the pace of change has only accelerated in recent years. What has driven their performance in recent years and how will their makeup evolve in the future?
The MSCI Emerging Markets Index was launched on 1 January 2001. From its inception to the end of September 2017, the index posted annualised gains of 9.89 per cent, versus 4.99 per cent for its developed markets counterpart, the MSCI World Index.
Though these figures are compelling, they mask the gut-wrenching volatility that has characterised this 16-year time period.
Emerging markets bounce back in 2017
The years between 2010 and 2016 have been particularly taxing for investors in emerging markets stocks, with indices falling over 1 per cent on an annualised basis, versus a gain of over 8 per cent for developed markets.
But after almost seven lean years, emerging markets equities have re-emerged in 2017. For the year to date to the end of September, the emerging markets index increased 27.8 per cent, while its developed markets counterpart rose 16 per cent.
The success of a pair of Chinese tech giants, Tencent and Alibaba, are a sign of the changing face of emerging markets; in contrast, commodity and Brazilian stocks have struggled in recent years.
The tech-led stock rally is not a US phenomenon; emerging markets are participating, too. The transition from a portfolio dominated by basic materials and energy giants to one led by emerging titans of technology has marked the most recent evolution of emerging stock markets, but what might come next?
China moves to centre-stage
MSCI's decision to include China A-shares in the index is recognition of the significant strides China has made toward opening its capital markets to foreign investors in recent years. Exchange-traded funds and index funds tracking the affected indexes will add some or all of the 222 A-shares earmarked for inclusion to their portfolios.
It is a significant first step toward greater global integration of the domestic Chinese capital market and will bring China's standing in equity indices more in line with the true footprint of the nation's capital markets and its economy at large.
Saudi Arabia is also on the shortlist for potential inclusion in emerging markets benchmarks. Further opening of the kingdom's capital markets and the potential for an initial public offering of oil giant Saudi Aramco could have a significant effect on the character of the pool of emerging markets stocks.
Diversification benefits dwindling
The level of correlation between developing and developed markets has increased significantly since 2001 and this means the benefits of investing in emerging markets to diversify has started to dwindle. As emerging markets start to integrate into the global economy, they will start to move in step with developed markets.
Investors should in future continue to expect a bumpy ride; these countries' economic progress will be lumpy and their stock markets' returns lumpier still.
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Ben Johnson is director of passive funds research at Morningstar, based in Chicago.
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